r∑MAP

Risk Enhanced Multi-Asset Portfolios

Systematically Reducing Portfolio Risk

Ask a fund manager about portfolio risk and they will reply mentioning the word diversification. Indeed “diversification”
features in most Due Diligence Questionnaire (DDQs), Request for Proposal (RFPs) and investment marketing material,
but usually as a poor substitute for a proper risk framework in the portfolio construction process. While we recognise
that diversification has to provide part of the approach to risk control, it is no panacea. Without a proper risk framework
in place, diversification will fail to provide the portfolio protection when it is most needed. That is easily verified by
looking at the performance of an APCIMS balanced benchmark through 2008 – the peak to trough loss was in the
order of 35%. We really don’t think that amounts to proper risk control in the minds of most investors!

Benchmarks are supposed to provide a stylised representation of a
well-diversified portfolio. The problem is that this kind of diversification
only works well when assets are not correlated. While that might be
the case most of the time, when assets do become correlated, the
theory breaks down dramatically. Here, we tease apart portfolio risk
into two component parts, systematic and non-systematic risk, in
order to reveal the futility of an over reliance on diversification as a
substitute for proper risk management.
Why non-systematic risk can be diversified away
Non-systematic risk is the type of risk that can be diversified away.
A portfolio holding a number of equities might have one company
reporting an unexpected loss and another reporting an earnings
surprise. The resulting share price movements could be expected to
offset each other as these two company specific events have opposite
impacts on the value of the portfolio, with no wider impact on the
market (or indeed the rest of the portfolio).
Role of the benchmark
Benchmarks are often used by managers as tools for setting asset
allocation ranges within their portfolios. Expanding on the previous
equity example, the FTSE100 index represents roughly 100 stocks
over a range of business activities. Holding a portfolio of stocks broadly
proportioned to the FTSE would therefore ensure a diversification
away from company specific effects. Indeed, multi-asset benchmarks
are often made up of single asset indices such as the FTSE100 and
the FT All stocks, again used to ensure diversification across a broad
range of assets and securities.
That’s fine most of the time, when markets are trading normally;
the spread of assets and securities if proportioned in line with a
benchmark will, in all likelihood, provide a broadly efficient mix of
assets. That is, that proportion of assets held in combination will result
in a lower level of volatility than the component parts, and probably
a higher return. That is the essence of portfolio diversification –
but it’s not job done!
Why the benchmark is inappropriate some of the time
While that kind of diversification might succeed in normal market
periods, when equities, for example, fall sharply and in a sustained
manner, they usually become highly correlated with other assets,
and with assets that they may not normally be correlated with.
This increased correlation quickly gives rise to increased portfolio
risk: because in a simple two asset portfolio, the level of risk is equal
to the risk in the first asset plus the risk in the second, plus twice
the covariance (or degree of correlation) between the two assets.
Given that correlation is a bounded version of covariance, a positive
correlation clearly adds to portfolio volatility.
Systematic risk
The problem is that not all risk is non-systematic. Looking again at
the equity example, if one company reports some unexpectedly bad
results, the first instinct of most market participants is to examine the
potential implications for the other companies in the sector. If the
bad news was explained by an industry specific event such as a new
law or regulation (banks being forced to de-lever for example) then it
would be reasonable to expect that other companies in that sector
would also be affected. In that case, the risk becomes systematic
across that sector. If the event can be explained by a wider event such
as higher interest rates, then all companies in that market would be
affected. These types of systematic risk (often referred to as market
risk) are not easily diversifiable because they are risks that affect
many securities and asset classes in the same way – and as such the
assets become increasingly correlated.
Systematic relationship between correlation and stress
Looking at this another way, when an asset class such as equities
takes an unexpected fall, other risk assets usually fall with them.
That is, they become correlated, even if they were not before,
particularly if the downward pressure on equities becomes protracted.
From the discussion above, that would feel like markets reacting
to some sort of systematic risk - a portfolio risk that is not easily
diversified away. Looking at the problem in this way has helped us to
define our proprietary Market Stress Indicator (MSI) which monitors
asset correlations and volatilities and uses them to define various
states of market stress, or periods where risk assets, such as equities,
are likely to underperform.
Our new multi-state risk framework does not under estimate
portfolio risk
Using the MSI as an input into our multi-state risk framework, we can
change the way in which we account for asset class correlations over
time. That is, unlike Modern Portfolio Theory (MPT) which assumes
that asset correlations and volatilities are stable, we assume explicitly
that they change, and that they change by market state as observed
by our MSI. That means that when we measure potential portfolio
risk, controlling for the market state, we are less likely to under-
estimate the potential portfolio risk in periods of market stress than
if we were using traditional MPT-driven techniques (as is standard in
the industry). That’s because we explicitly assume that asset class
correlations are higher during these periods, meaning higher portfolio
risk too.
Moving away from the benchmark allows us to cap portfolio risk
Correctly measuring portfolio risk is not enough either - we need
to go further. At times of market stress, we will aim to reduce
portfolio risk in line with our clients’ stated risk tolerances or below.
In a stressed market that often means selling risk assets to levels far
below the benchmark. Indeed at times of maximum market stress,
our risk adjusted portfolios will typically look very different to their
benchmark, and possibly relatively concentrated (or undiversified).
That’s because systematic risk requires a very different approach to
portfolio management.
Diversification may be appropriate – but it’s not a panacea –
it will not help when needed most
Diversification is clearly an important aspect of managing portfolio
risk most of the time but that is very different from suggesting
it’s a sufficient approach to managing risk all of the time. In fact,
it’s the unusual market events that tend to have the most meaningful
and detrimental impact on portfolio returns and it’s the avoidance
of (or at least minimising) these losses that has a surprisingly large
impact on long term portfolio returns. When capital preservation and
improved risk adjusted returns are the priority (as most of our clients
say they are), don’t just look to a well diversified portfolio, because it
probably isn’t enough to meet your objectives in today’s challenging
investment environment.

Investment involves risk. The investments discussed in this document may not be suitable for all investors. Investors should make
their own investment decisions based upon their own financial objectives and financial resources and, if in any doubt, should seek
advice from an investment advisor. Past performance is not necessarily a guide to future performance. The value of investments
and the income from them can go down as well as up and investors may not get back the amount originally invested.
Collins Stewart Wealth Management is a trading division of Canaccord Genuity Limited, which is authorised and regulated by the Financial Services Authority.
Registered Office: 9th Floor, 88 Wood Street, London EC2V 7QR. Registered in England & Wales no. 1774003.

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